von Holger Langer, LL.M.

Project Finance

A. Definition of project finance

“project finance” is generally used to refer to a non-recourse or limited recourse financing structure for the construction and operation of a particular facility, in which lenders rely on the assets of the facility, including any revenue-producing contracts and other cash flow generated by the facility, rather than the general assets and credit of the sponsors or the borrower, as collateral for the debt

covers a wider range of financing structures, which have in common that they rely in the first place on the performance of the project (and the revenues generated by it) rather than the physical assets of the borrower

as a result the lenders concern will primarily involve the technical feasibility and economic viability of the prospective project

no strict definition of project finance, but will usually involve the following elements

some element of reliance on project assets and cash flowswithout full recourse to the sponsors or, as the case may be, the borrower

technical and economic evaluations of the project and the customer’s business, on-going monitoring by the lender

lengthy and complex loan documentation

higher margins and fees to reflect the lender’s exposure to the project risks

I. Non-recourse project finance

relying completely on the merits of a project (project assets and underlying cashflow from the revenue-producing project contracts)

independent of the non-project assets of the project sponsor

sponsor has no direct legal obligation to repay the project debt or make interest payments if the project cash flows prove inadequate to service debt

would result in no potential liability of the project sponsor for the debts or liabilities of the project, and is therefore rarely used in practice

II. Limited-recourse project finance

limited obligations and responsibilities of the project sponsor

the extent of the necessary recourse is depending on the unique risks that are involved in each individual project

often mixture, e.g. a limited recourse to the sponsor’s assets for substantial risks during the construction phase of the project until the risk subsides (e.g. minimum performance tests) or construction is complete and, thereafter, loan would be non-recourse

B. Contrast with other financing types

I. Balance sheet finance

Structure

retained earnings or short-term debt to develop and construct the project

upon completion, long-term debt, equity sales or other corporate finance techniques to obtain the needed funds for the permanent financing of the project

focus of the credit decision is not the stand alone project, but the entire company of the borrower, including the cash flow and assets and the effect of the new project on the company’s continued viability

relevant criteria for decision

access to the needed capital at reasonable costs

acceptable return on investment under the project feasibility study

satisfactory project risks

II. Asset-based finance

founded on the value of the assets financed

in the context of projects, the hard assets would probably not produce sufficient cash in a foreclosure sale to justify the value of an asset-based loan

C. Advantages of project finance to the sponsor

I. Elimination of, or limitation on, recourse to the sponsor

non-recourse project financing provides financial independence to other projects owned by the sponsor

protects the sponsor’s general assets from difficulties in a particular project

II. Avoidance of restrictive covenants in other arrangements that would preclude project development

structure permits to avoid e.g. cross-default, since the project financed is separate and distinct from other operations and would not be influenced by other defaults (as long as this default does not occur on the parent company level)

III. Favourable financing terms

project finance may permit for arrangement of attractive debt financing which is available to the project (depending on the risk profile and the prospective profitability), but which is unavailable to the project sponsor as a direct loan (because of its financial condition)

more attractive interest rates

more attractive credit enhancement

IV. Political risk diversification

the separation of the project finance from other projects in a non-recourse structure with the establishment of project-specific entities serves the diversification of political risks

the economic effect of a political risk in one country does not affect other projects of the same sponsor in other countries

V. Risk sharing

project finance structure permits the sponsor to spread risks over all project participants, including the lender

can improve the possibility of a project success since each participant accepts risks and is interested economically in the project success

however, the allocation of risks to other participants will invariably increase the costs for the sponsor, but will be accepted as a necessary element of non-recourse or limited-recourse project financing

VI. Limiting collateral to the project assets

non-recourse project finance loans are generally based on the premise that the only collateral that the project must pledge to the lenders as security for the loan is the project assets

VII. Facilitation of workouts

in the case of financial difficulties of the borrower, there is usually little that the lenders can do apart from a workout

since in a non-recourse finance the loan is primarily secured by the future revenues, the lenders have a stronger interest in a project success, since the debt can only be repaid if the operation of the project generates some revenues

the project assets alone are of little value and have value only with the project contracts

the project contracts have value only if the facility operates

VIII. Matching of specific assets with specific liabilities

project finance allows to match specific assets with specific liabilities by segregation of the assets of the project from other projects and from other assets of the sponsor and assign them to a specific liability

thus the evaluation of individual project profitability is facilitated

D. Disadvantages of project finance

I. Complexity of risk allocation

if a project is to be successful, risks must be allocated among the participants in an economically-efficient way

however, there are necessary tensions between the participants, e.g. between the lender and the sponsor regarding the degree of recourse, between the sponsor and the contractor regarding the nature of guarantees etc., which may slow down the realisation of the project

II. Increased lender risk

the degree of risk for the lender in a project financing is not insignificant

although the bank is not an equity risk-taker, many risks cannot be effectively allocated or enhanced

this results in higher transaction costs compared to other types of transactions, because it requires an expensive and time-consuming due diligence conducted by the lender’s lawyer, the independent engineer etc., since the documentation is usually complex and lengthy

III. Higher interest rates and fees

similarly, the interest rates and fees charged in a project financing may be higher than on direct loans made to the project sponsor

IV. Lender supervision

in accordance with the higher risks taken in a project financing, the lender will impose a greater supervision on the management and operation of the project to make sure that the project success is not impaired

the obligations of the borrower / sponsor in regard to this supervision (satisfaction of certain test, restrictions imposed on the borrower etc.) will be incorporated into the project loan agreement

the degree of lender supervision will usually result in higher costs, which will typically have to be borne by the sponsor

E. Types of project finance

Loan

most conventional structure is a limited or non-recourse loan, repayable out of project cash flows

basic structure may be adapted by credit enhancements e.g. export credits given by export credit agencies

the borrowing entity will often be a limited liability vehicle established by the project sponsors, in which case the documentation might not provide for any overt restriction on recourse, the lenders accepting that the repayment obligation is that of the vehicle (the project company with its assets), not of the shareholders

however, if the borrowing entity is not a vehicle with limited liability, then the limitation on recourse has to be dealt with in the documentation in clear terms

loan agreement will recognise at least two distinct stages

Construction or development phase

loan funds will be disbursed

debt service will be postponed by rolling-up interest pending the generation of revenues (cash flows) in the operation phase

period of highest risk for the lenders, therefore not uncommon to have either full recourse financing at this stage, e.g. through legally binding guarantees of the project sponsors or, alternatively, higher margins than in other phases of the project

full recourse or higher margins may then fall away upon the satisfactory completion of the project by previously agreed and documented standard, which are usually verified by independent experts in various tests

Operation phase

the completion of such tests will mark the beginning of the operating phase when cash flows can be expected

the debt will then start to be serviced and/or amortised

the rate of debt service and repayment will be related to the anticipated level of output and receivables of the project (part of which will usually go to the lenders automatically, e.g. by assignment)

Production payments

technique involves the lenders establishing a special purpose vehicle to purchase an undivided interest in the product of the project company

the financing being the purchase price, the exclusive source of repayment and debt service is the production of the project

the project company will usually be obliged to repurchase the product or to sell it in the market as agent of the lenders to realise cash (as repayment and debt service)

method of achieving non- or limited recourse financing with complete security, i.e. through ownership rather than through assignment or mortgage

Forward purchase (Similar to production payment, but more flexible)

BOT

F. Project risk identification and allocation

risk has been defined as an uncertainty in regard to cost, loss, or damage (uncertainty being the crucial point)

factors outside the control of the parties, such as fire, flood, earthquake, war, rebellion, strike etc.

affecting the project itself or contractors, suppliers or markets for the products

technical failures and difficulties

accidents

Minimisation

ensuring that the project has binding and enforceable long-term fixed price contracts for supplies, energy, transportation and the like

the project establishing its own sources and infrastructure (e.g. project specific power generating plants)

performance bonds and completion guarantees given on behalf of contractors in favour of the project sponsors and assigned to the lenders

commercial insurances and export credit guarantee support

strict provisions in the underlying documentation with contractors and suppliers to penalise delay, fix costs and secure performance (benefit of which is passed on to the lenders by assignment of such contracts)

II. Market and operating risk

existence of local and international markets for the product

likely strength of competition, projections for prices, tariffs and existence of trade barriers

access to markets

physical access (transportation, communication)

commercial access (freedom to sell the product, governmental control of the market)

obsolescence

will the product still be wanted by the time of operation?

technology risk (technology still up to date?)

new technology

risk of delays, cost overruns and outright failures if technology is untried

risk of lagging behind more innovative competitors

Minimisation

Long-term take-or-pay contracts, throughput agreements (pipelines) or tolling agreements can guarantee a market for the product at a price that can be tailored to cover operating expenses, debt service and repayment

In electricity generating projects there will often be only one possible consumer, a national or local grid

negotiation of minimum off-take amount and minimum prices

alternatively, fee arrangements with further fees payable for the amount of power produced

III. Financial risks

fluctuation in exchange rates

increases in interest rates

increases in commodity prices on world markets, especially for energy and raw material

falls in the price of the product on world markets

inflation

protectionism

Minimisation

hedging facilities against exchange rate and interest rate risks by way of currency or interest rate swaps, caps, collars, floors and other techniques

debt service and repayment profile can be formulated by reference to a number of factors including market prices, inflation rates etc.

protection against a fall in the price of the product through hedging facilities such as forward sales, futures and options contracts etc.

IV. Political risks

external hostilities (war), civil war, revolution

government action (external or internal) through sanctions or freezing orders

V. Legal risks

especially because in developing countries the legal systems are less sophisticated and judicial support is harder to obtain

lack of legislation

taking and enforcement of security

preclusion of property

enforcement of security is of crucial importance in a facility with limited recourse

dispute resolution problematic

no equal access to the courts for foreign parties

foreign judgments not enforceable

ability to resort to arbitration restricted

accordingly, status and enforceability of arbitration awards uncertain or unsatisfactory

inadequate protection of intellectual property rights

inadequate regulation of fair trading and competition

whole legal system might be slower, more expensive, less predictable

limitation on appeal rights

environmental legislation (both existing and prospective)

Minimisation

thorough review of legal risks at an early stage by consultation of local lawyers and host governmental offices (department of justice, attorney general etc.)

legal opinions to ambiguous or unclear questions

G. Security

non- or limited recourse structure makes it necessary to secure the project finance (in contrast to a customary loan)

purpose of security

to prevent disposal of assets by the borrower or the granting of interests to third parties

to take possession of and realise assets ahead of other creditors

fundamental considerations

Does the borrower have sufficient ownership interests in the assets that allow him to effectively grant security?

Over which project assets can security be effectively created?

Which possibilities are given by the applicable law as to the nature of security instruments (can mortgages be given?, are floating charges possible?)?

Which creditors will – in case of insolvency – be preferred to secured creditors?

How can security be enforced by the lenders?

What formalities have to complied with to perfect security?

Can security be held by a trustee or by an agent for a group of creditors (with the possibility to change the beneficiaries, i.e. the members of such group), e.g. for the facilitation of transfer of loan participations?

in many cases, project finance will take the form of a syndicated loan, although other types of finance, which do not involve conventional borrowing, such as forward purchase agreements or production payments, are just as common (similarly, depending on the complexity of the project, innovative finance structures will frequently be tailored to the requirements of the particular project and its specific features)

however, project finance is characterised by some peculiarities which would normally not be covered by conventional syndicated loan facilities

some element of reliance on project assets without full recourse to the borrower / sponsor

technical and economical evaluations of the project and the customer’s business, which are continually monitored by the lenders

lengthy and complex loan documentation

higher margins and fees to reflect the lender’s exposure to the project risks

the realisation of projects involves a legion of risks that cannot be borne by one party alone

the idea behind project finance is therefore to distribute the risks of the project among all participants in an economically efficient way

risk structuring is therefore the crucial part of the finance structure

the lenders are merely taking particular risks themselves, since most of the risks will be allocated to the parties most closely connected with certain risks, such as the contractor, the sponsor, the host government etc. but they will most likely have effects on the lender’s position (e.g. the risk of cost overrun which has been allocated to the contractor may negatively affect his creditworthiness and financial constitution and might therefore impair the completion of the project construction, which will again threaten the debt service and repayment of the finance)

projects will frequently be regarded as stand-alone projects, and the finance structure will, thus, usually rely on the project assets and cash flows alone without full recourse to the borrower

accordingly, the lenders will try to protect their position by taking security of the projects assets and future revenues

this differs fundamentally from the position in conventional loans which are usually unsecured and which would therefore by other means try to ensure that the lenders will be in a favourable position on bankruptcy, e.g. pari passu ranking with other creditors or maximal assets for distribution between unsecured creditors by negative pledge clauses

likewise, repayment and debt service will usually be limited or postponed until the completion of the project and the commencement of the operation phase, since payments are based on the (future) generation of revenues

the lenders’ commercial interest is therefore depending on the success of the project

accordingly, the lenders will take a much more active role in monitoring and supervising the project, as they would normally do in conventional syndicated loan facilities

all these particularities will be reflected by the loan documentation, which will be lengthy and complex and will usually provide

for special clauses dealing with security (which would not be part of a conventional syndicated loan) and calling for particular security documents, such as mortgages on immovable property, fixed or floating charges on movable property, pledges on the project company’s shares (plus charges on the prospective dividend interests), assignments and step-in-right documents of all underlying and supporting contracts with third parties etc.

the supply of such documents will usually be made a condition precedent to the disbursement of funds

the loan agreement will, furthermore, call for legal opinions stating that the security granted by the borrower will be legally valid and enforceable under the applicable law; the supply of such legal opinions will likewise be made a condition precedent

the covenants will – in addition to the general and financial covenants, which also form part of the conventional loan – contain a part on operational covenants that cover the borrower’s obligations in regard of the construction, development and operation of the project

in this context, the loan agreement is likely to cover the contents of technical and economical feasibility studies, since debt service and the repayment profile will to a large extent depend on the projections of future cash flows therein

last, but not least, the higher exposure of lenders to risks, the complexity of the necessary preliminary work (risk management, feasibility studies, expert opinions, legal opinions), the resulting lengthy and complex loan documentation and the continuing involvement of the lenders in supervision and monitoring of the project progress will add to the transaction costs of the lenders and will normally result in significantly higher margins and fees, compared to conventional loan facilities